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I met a pension fund manager the other day. He runs the $10bn pension fund for the employees of a large US city. He is looking to allocate to more hedge funds but he told me the simple problem he has: “I have looked at more than 3,000 hedge funds. It is difficult to find a hedge fund that is truly uncorrelated to stocks. If I want stocks then I can always put the money in exchange-traded funds and vary the leverage depending on what beta I want.”

For the past three years the S&P Hedge Fund index has followed the direction of the S&P (up or down) in 34 out of the 36 months.

The other day I came across a start-up fund that seems completely uncorrelated. It is more linked to the fate of defendants in lawsuits ranging from large class action suits in tobacco cases to securities class action suits.

Several existing hedge fund groups are exploring this niche, and some are already up and running. With any unique hedge fund strategy, an anomaly or arbitrage of sorts has to exist. Why is there a gaping hole in liquidity that the hedge funds can fill?

That brings us to contingency fee litigation. In many class action suits the payoff is enormous, clients usually do not have the resources to pay (and often the payoff is not as big for the clients on a one-off basis) so the lawyer is willing to take on risk based on his estimation that the case is going to conclude successfully.

The lawyer would like to share some of that risk but it is not legal for lawyers to share their fees with non-lawyers.

So here is the anomaly, caused by regulation, for lawyers. In just about any other industry, a company can share risk and raise money to pursue speculative ventures by carrying out an initial public offering or doing a venture financing. Investors participate directly in the success of the speculative venture because they own a piece.

Law firms cannot do this. Not only that, it is very difficult to value the assets of a law firm. The assets, other than the people, are the future cash flows of the legal battles they are engaged in. Estimating the success of those lawsuits and future cash flows is extremely difficult.

The fund I spoke to is still in start-up mode and did not want its name to be revealed. That said, it still talked to me about the challenges law firms face at the moment.

The problem firms had, it said, was that they still had to provide all their upfront costs. Total tort costs in the US reached $260bn in 2004, or about $886 for every person in the US. These can be expected to continue rising.

Given that the payback is so enormous for the law firms involved, the fund told me, they are willing to borrow at up to Libor plus anywhere from 1,000 to 2,000 basis points. But even then it is hard to find lenders because the collateral is so difficult to analyse. Banks are comfortable making 30-year loans against a house, or factoring receivables on a steady business, but they lack the experience of lending against a portfolio of lawsuits.

There are several reasons for this. The first is uncertain timing. “The typical case can be over in anywhere from less than a year if there is a settlement, to five or six years where it is drawn out by appeals,” the fund said.

Second, there is no secondary market. Unlike mortgages, which are securitised and packaged for the secondary markets, no such market exists in litigation finance.

But without the access to capital, law firms and their clients are up against the deep pockets of the insurance companies or the other larger defendants in the big class action suits.

“We lend to law firms to help them reduce that risk and we reduce our own risk through our analysis of the collateral as well as through diversification,” said the hedge fund.

“What we do is analyse the risk using historical analysis of similar cases, the track record of the law firm and its historical cash flows.

Hedge funds cannot fund any individual lawsuit directly, and their returns are not contingent on the success of a lawsuit. Instead, they fund the law firms themselves, with loans backed by cash flows from the firm as a whole, and from personal guarantees from attorneys.

Like any portfolio, an important way a litigation finance hedge fund reduces risk is through diversification – not only by loaning out to many different law firms but by spreading those loans geographically as well as by type of litigation.

And there is a range to be covered: mass torts such as drug litigationor problems with medical devices, class action litigation such as securities litigation, antitrust cases, or consumer cases, and even single-incident litigation ranging from motor vehicle accidents to medical malpractice and products liability.